How does it work? The U.S. Treasury issues Treasury bonds (T-bonds) to the open market. The Federal Reserve purchases T-bonds.
Effects of QE? Quantitative easing has many effects on capital markets and the general economy.
First order effect: Interest rates. When the Fed buys T-bonds under QE, it reduces the supply of outstanding Treasuries, driving up the price of the remaining bonds and driving down yields (interest rates). The lower sovereign yields act as a source of “free money” for nations. Lower interest rates mean governments spend less to pay off their loans/debts, freeing up spending that can be used for other programs.
Second order effect: Consumers. The lower sovereign interest rates reduce consumer financing costs for such things as housing/mortgages, autos, credit cards, etc.
Third order effect: Investor behavior. The lower interest rates force risk-seeking investors to move out the risk spectrum to maintain a constant expected return level.
QE starts off with the Fed serving its role and acting as the lender of last resort to maintain liquidity stability. The second and third order effects, however, result in QE acting as a fiscal stimulus plan -- that’s when the independence and the role of the Fed come into question. The picture gets cloudier when precautionary/insurance interest rate cuts start to look more and more like masked fiscal stimulus.
Other Considerations: If the Fed anchors rates at a low level, there’s no effective limit to how much the Government can borrow; it can just keep increasing and rolling over its debt at minimal cost. By choosing to repress rates, the Fed is treating all concerns as temporary, transitory and liquidity focused.
There are long term consequences to QE. First, nationalizing the capital markets impairs the free-market price discovery process. Second, monetary policy is only credible when debt dynamics are sustainable, and unlimited debt issuance is not sustainable.
How far can monetary policy makers extend QE? Critics of QE describe it as a self-imposed weapon of destruction. Excessive QE will likely lead to rising default concerns (credit downgrades), currency devaluation and rising inflation.
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